The Competitive Relationship Between Mainstream and Microfinance Banks
Microfinance today is a far-ranging and dynamic sector that offers loans, provides savings and remittance services, and sells insurance to more than 100 million of the poor. Microfinance companies have increased in complexity and diversity in the income levels of the customers they serve, their use of subsidies, regulation and governance structures, and the breadth and quality of services offered.
Until recently, these organizations devoted themselves to filling market niches, with seemingly little interaction with the rest of the banking system. Nonetheless, in the last few years, the microfinance industry has expanded and broadened its focus. Within the microfinance landscape and measured by loan size and target customer, two groups of institutions are beginning to become apparent: the microfinance commercial bank and the microfinance nongovernmental organization (NGO) (Cull, Demirgüç-Kunt and Morduch, 2009a).
The average loan size provided by a microfinance NGO is approximately less than a quarter the size of the average loan provided by a microfinance commercial bank (Cull, Demirgüç-Kunt and Morduch, 2009a). Smaller loan sizes translates directly into higher relative costs. Since poorer clients take smaller loans, reaching the very poor is associated with higher average costs per loan which need to be covered with higher interest rates and/or subsidies (Cull, Demirgüç-Kunt and Morduch, 2009a). Therefore, while microfinance commercial banks are able to attract investors seeking commercial returns, NGOs will usually depend on subsidies.
In parallel with the expansion in complexity and diversity of microfinance institutions, mainstream commercial banks have started targeting those at the upper rungs on low-income markets. In particular, the best clients from microfinance commercial banks are now able to signal their creditworthiness to mainstream commercial banks. Moreover, since these clients have now generated financial information, the mainstream commercial bank will not need to rely on ’soft’ information in their analysis of the customer.
As a result, the prospect for interaction and direct competition has increased sharply. Microfinance and mainstream commercial banks have recently started to take into account the competitive interactions between these two groups and have begun to shape their products and target segments accordingly. Hence, we are currently seeing how microfinance and mainstream commercial banks are evolving in a direction charted by their joint strategic interaction by playing to their competitive strengths ’vis-à-vis’ the opposing group.
How exactly does this competition affect each other? In a previous post, I briefly examined one example of how mainstream commercial banks where playing to their competitive strengths in the microfinance market. These institutions have greatly invested in the development of transactional technologies such as credit scoring and standardized risk-rating tools and processes. Moreover, they have started to develop specially targeted products such as asset-based lending, factoring, fixed-asset lending, and leasing (de la Torre, Martinez Peria and Schmukler, 2008). As a result, their risk management systems are comparatively very superior to those of microfinance commercial banks. Additionally, they can take recourse to their service platforms, technical expertise, and IT and back-office infrastructures. These competitive advantages have led mainstream microfinance banks to finance clients, such as Small Medium Enterprises, which require wider-encompassing financial services and thus a more complex evaluation of the risks involved. Nonetheless, their evolution is something that remains to be researched properly.
How have microfinance commercial banks evolved in response to the competition from mainstream commercial banks? A recent study has found that, although competitive pressure seems not to significantly reduce their profitability, microfinance commercial banks have responded by penetrating deeper into poorer markets, thus reducing their average loan size and increasing their outreach to women. (Cull, Demirgüç-Kunt and Morduch, 2009b). On the other hand, mainstream commercial banks have not been found to impact the commercial behavior of microfinance NGOs (Cull, Demirgüç-Kunt and Morduch, 2009b).
This means that, subject to competitive pressures, microfinance commercial banks have sought refuge in the core expertise that allowed them to succeed in low income markets in the first place: ’relationship lending’. This lending mechanism relies primarily on ’soft’ information gathered by the loan officer through continuous, personalized, direct contacts with customers and the local community in which they operate (Berger and Udell, 2006). These banks have sought to revisit and reinvent relationship lending in order to develop financial products targeting a population segment that might have been bypassed. In this line, one recent example is provided by Vittana (featured in this post) and its development of student loans making use of “soft information” gathered by the microfinance commercial banks with which it had partnered.
However, it would be a mistake to believe that the relationship between microfinance and mainstream commercial banks can only be of a competitive nature. The fact that each group possesses different competitive advantages lays the ground for a cooperative relationship in which each can contribute its own strengths. Microfinance commercial banks’ own customer platforms are characterized by an excellent capillarity and the generation of useful financial information out of the ’soft information’ gathered from their low-income customers (the potential of these platforms were profiled in a previous post here). Mainstream commercial banks have more extensive internal resources and capabilities that can be devoted to offering more comprehensive financial services and simultaneously improving customer risk assessments.
Microfinance and mainstream commercial banks have a lot to learn from each other. Although it has been barely analyzed, their competitive relationship is already shaping the microfinance landscape. It is to be expected that, as the microfinance product portfolio becomes more sophisticated and complex, the interaction between these two groups will become increasingly relevant in the direction the industry takes in years to come.